Japan's Liquidity Trap

Japanese long bonds are starting to slowly collapse. Will the BoJ allow true deflation in the land of yield curve control?

I’ve been writing about the Japanese economic calamity for some time now, and this week, a new front has emerged in this monetary war. Ever since the implosion of the Japanese real estate and equity markets and the 1990s and the subsequent depression that followed, the Japanese central bankers have been playing a game of catch up with the market and broader economy.

This island nation is unlike any other- and as it entered a demographic, monetary, and economic collapse in the 1990s, new ideas were brought to the fore to handle the growing crisis.

The Japanese economy writ large has become a monetary lab, where central bankers and policy makers dream up new financial schemes in smoke filled lounges and try enacting them on a population of 124 million

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This first began with their foray into zero bound interest rate policy (ZIRP) in 1999 and continued with their trial run of QE in March 2001. These monetary experiments did not prove to be successful in stimulating the Japanese market sufficiently, but they did in the end slow the deflationary train wreck that was the 1990s.

The reason these new monetary policies were not effective was not necessarily because of the issues with the policy themselves, but with the Japanese economy as a whole- it had become a large scale liquidity trap in the aftermath of the 1990s deflationary collapse.

In most economic slowdowns, central banks respond by lowering interest rates. The idea is simple: make borrowing cheaper so that consumers and businesses are more likely to spend, invest, and hire. Under normal conditions, this strategy works. But in a liquidity trap, it doesn’t.

This is an economic situation where further monetary stimulus has little to no effect on economic activity. People and businesses facing uncertainty or deflation in the aftermath of the bubble, prefer to hold on to their cash rather than spend or invest it, even if central banks flood the system with money. The usual tools of monetary policy become ineffective because the core problem isn’t a lack of money; it’s a lack of confidence, opportunity, or incentive to use it.

This dynamic creates a kind of paralysis. Money is available and cheap, but it does not move (i.e. velocity collapses). Consumers save instead of spend. Businesses delay investments. Banks hold onto reserves. Central banks can continue to inject liquidity into the financial system, but the extra money simply sits idle, like water in a sponge that refuses to release it.

Furthermore, their system optimizes for stability rather than growth or innovation- this means that on the macro scale, Japan is largely missing the vibrant angel investing and startup culture of the United States.

Innovation just doesn’t happen here, something that was pointed out to me very starkly by Weston Nakamura when I was in Japan back in March. He asked me if I could name the Japanese Mark Zuckerberg, or the Japanese Elon Musk- or really any entrepreneur or innovator from Japan that didn’t deal in cultural or media industries like anime or manga. I couldn’t.

He continued to make the point that because of this rigid structure most companies in Japan do not actively promote star workers or hire new people to create new projects. If you have an idea in corporate Japan and you’re not a manager, you have to just shut up and do your work because it’s not your place to tell anyone else what to do.

What it means functionally is that lower interest rates do cheapen the cost for borrowing but nobody necessarily needs to borrow because no one has any new projects they want to take on- no new app ideas, no new robotics companies, basically no innovation at all.

The companies that most of us point to the Japanese behemoth like Toyota, Sony or Panasonic became successful by simply becoming more efficient in their manufacturing processes and optimizing their supply chains while maintaining reliability and quality for their products. This is a type of innovation, but not the one that is groundbreaking like we see in Silicon Valley.

Making a better mouse trap is not equivalent to making a robotic cat that can catch mice for you.

Ronald McKinnon, writing for the Economist in 1999, puts it best:

“Relatively lower nominal interest rates were not a problem for the Japanese so long as American rates remained high, because of inflationary expectations. But when the Federal Reserve convincingly stabilised the price level by the mid-1990s, and interest rates came down, Japanese rates were driven toward zero. Thus, in the late 1990s, the liquidity trap in Japan has been externally imposed—as an incidental, rather than deliberate, outcome of American policies.

Taking this long-term exchange-rate expectation as given, consider Japan's current monetary-policy dilemmas. The BOJ cannot use the ordinary instruments of monetary policy to reflate the economy. Nominal interest rates on yen assets cannot be reduced below zero. Nor can the present “equilibrium” value of the yen depreciate significantly in the face of Japan's large trade surplus.”

It’s commonly known in finance that generally bond markets and currency markets are diametrically opposed; saving one necessitates sacrificing the other to the whims of market forces, which are usually against where the central planners want them to be.

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Driving interest rates to zero therefore should have a negative affect on your currency. Lower rates domestically mean that it’s better for people to invest abroad- which puts downward pressure on the FX rate.